Edgar Filing: ACA Capital Holdings Inc

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

Form 10-Q

x		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		For the Quarter Ended September 30, 2007

		or

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission file number 1-33111

ACA Capital Holdings, Inc.

(Exact name of registrant as specified in its charter)

Delaware		75-3170112
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

140 Broadway

New York, New York 10005

(212) 375-2000

(Address, including zip code, and telephone number, including

area code, of registrant’s principal executive offices)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o

Accelerated filer o

Non-accelerated filer x

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

As of November 9, 2007 34,851,780 shares of Common Stock, par value $0.10 per share, were outstanding.

INDEX



PART I - FINANCIAL INFORMATION

Item 1.	Financial Statements of ACA Capital Holdings, Inc. and Subsidiaries (Unaudited)	3

	Report of Independent Registered Public Accounting Firm	3

	Condensed Consolidated Balance Sheets (Unaudited) — September 30, 2007 and December 31, 2006	5

	Condensed Consolidated Statements of Operations (Unaudited) — Three and nine months ended September 30, 2007 and 2006	6

	Condensed Consolidated Statements of Stockholders’ Equity (Unaudited) — Nine months ended September 30, 2007 and 2006	7

	Condensed Consolidated Statements of Cash Flows (Unaudited) — Nine months ended September 30, 2007 and 2006	8

	Notes to Unaudited Condensed Consolidated Financial Statements	9

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	23

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	53

Item 4.	Controls and Procedures	55

PART II - OTHER INFORMATION

Item 1.	Legal Proceedings	55

Item 1A.	Risk Factors	56

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	58

Item 3.	Defaults Upon Senior Securities	59

Item 4.	Submission of Matters to a Vote of Security Holders	59

Item 5.	Other Information	59

Item 6.	Exhibits	59


SIGNATURES		60

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements of ACA Capital Holdings, Inc. and Subsidiaries (Unaudited)

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of

ACA Capital Holdings, Inc.

New York, New York

We have reviewed the accompanying condensed consolidated balance sheet of ACA Capital Holdings, Inc. and subsidiaries (the “Corporation”) as of September 30, 2007, and the related condensed consolidated statements of operations for the three-month and nine-month periods then ended, and of stockholders’ equity and cash flows for the nine-month periods then ended. These interim financial statements are the responsibility of the Corporation’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to such condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 5 to the condensed consolidated interim financial statements, the financial statements include derivative assets and derivative liabilities valued at $152.4 million (3% of net assets) and $1,897.2 million (33% of net liabilities), respectively, as of September 30, 2007, whose fair values have been estimated by management in the absence of readily determinable fair values. Management’s estimates are based on market quotes from dealers or internal models, which utilize current market information. Additionally, as discussed in Note 10, the financial statements include investments valued at $2,772.6 million (56% of net assets) as of September 30, 2007, whose fair values have been estimated by management in the absence of readily determinable fair values. Management’s estimates are based on market quotes from dealers or internal models, which utilize current market information.

As discussed in Note 16 to the condensed consolidated interim financial statements, on November 9, 2007 Standard & Poor’s Rating Services (“S&P”) placed its financial strength rating of ACA Financial Guaranty Corporation (“ACA FG”), a wholly owned subsidiary of the Company, on “CreditWatch with negative implications”. Should S&P ultimately downgrade ACA FG’s financial strength rating below “A-”, under the existing terms of the Company’s insured credit swap transactions, the company would be required to post collateral based on the fair value of the insured credit swaps as of the

date of posting. The failure to post collateral would be an event of default, resulting in a termination payment in an amount approximately equal to the collateral call. This termination payment would give rise to a claim under the related ACA FG insurance policy. Based on current fair values, neither the Company nor ACA Financial Guaranty would have the ability to post such collateral or make such termination payments.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of ACA Capital Holdings, Inc. and subsidiaries as of December 31, 2006, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated March 30, 2007, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2006 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ Deloitte Touche LLP

New York, New York

November 19, 2007

ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

AS OF SEPTEMBER 30, 2007 AND DECEMBER 31, 2006

(Dollars in thousands)

	September 30,			December 31,
	2007			2006
ASSETS
Investments:
Fixed-maturity securities available for sale at fair value, amortized cost of $3,808,777 and $5,043,239, respectively	$	3,373,228		$	5,026,276
Fixed-maturity securities trading at fair value, amortized cost of $133,333 and $251,884, respectively	125,176			251,825
Securities purchased under agreements to resell	1,000			10,248
Guaranteed investment contract	—			119,340
Total investments	3,499,404			5,407,689
Cash:
Cash and cash equivalents	283,240			379,905
Restricted cash	51,488			67,061
Total cash	334,728			446,966
Accrued investment income	15,805			21,222
Derivative assets	152,382			19,730
Deferred policy acquisition costs, net	50,839			48,810
Deferred debt issuance costs, net	17,477			34,104
Receivable for securities sold	4,339			824
Prepaid reinsurance premiums	464			528
Deferred income taxes	781,668			—
Other assets	95,558			58,321
Total assets	$	4,952,664		$	6,038,194

LIABILITIES, MINORITY INTEREST AND STOCKHOLDERS’ EQUITY
LIABILITIES
Unearned premiums	$	196,842		$	189,537
Reserve for losses and loss adjustment expenses	42,878			42,113
Short-term debt	2,675,308			2,677,828
Long-term debt	672,140			2,125,914
Related party debt	100,000			100,000
Securities sold under agreements to repurchase	104,124			232,227
Derivative liabilities	1,897,207			33,874
Accrued interest payable	7,584			17,900
Accrued expenses and other liabilities	82,816			61,855
Payable for securities purchased	37,457			9,628
Current income tax payable	10,080			7,056
Deferred income taxes	—			258
Total liabilities	5,826,436			5,498,190
MINORITY INTEREST	9,520			30,190

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS’ EQUITY
Common stock of 100,000,000 shares authorized at September 30, 2007 and December 31, 2006; 37,444,873 and 37,375,123 shares issued at September 30, 2007 and December 31, 2006, respectively; and 34,505,126 and 36,523,276 shares outstanding at September 30, 2007 and December 31, 2006, respectively; par value of $0.10	3,744			3,737
Gross paid-in and contributed capital	442,299			438,935
Treasury stock at cost —2,939,747 and 851,847 shares at September 30, 2007 and December 31, 2006, respectively	(27,084		)	(12,088		)
Notes receivable from stockholders	(3,121		)	(3,121		)
Deferred compensation	—			(870		)
Accumulated other comprehensive loss — net of deferred income tax of $(140,737) and $(1,760) at September 30, 2007 and December 31, 2006, respectively	(261,216		)	(3,308		)
Retained earnings (deficit)	(1,037,914		)	86,529
Total stockholders’ equity	(883,292		)	509,814
Total liabilities, minority interest and stockholders’ equity	$	4,952,664		$	6,038,194

See notes to unaudited condensed consolidated financial statements.

ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006

(Dollars and shares in thousands, except per share amounts)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2007			2006			2007			2006
REVENUES:
Gross premiums written	$	7,113		$	5,570		$	27,632		$	26,085
Less premiums ceded	(380		)	(189		)	(1,141		)	(375		)
Net premiums written	6,733			5,381			26,491			25,710
Increase in unearned premium reserve - net	(1,205		)	3,213			(7,369		)	(3,759		)
Premiums earned	5,528			8,594			19,122			21,951
Net insured credit swap revenue	(1,627,460		)	17,079			(1,667,944		)	39,190
Net investment income	87,471			87,888			268,018			248,052
Net realized and unrealized gains (losses) on investments	19,514			(752		)	(94,336		)	(3,975		)
Net realized and unrealized gains (losses) on derivative instruments	(2,397		)	755			2,939			6,894
Other net credit swap revenue	2,794			2,090			18,951			7,634
Fee income	9,562			6,516			23,490			17,589
Other income	57			342			412			446
Total revenues	(1,504,931		)	122,512			(1,429,348		)	337,781

EXPENSES:
Loss and loss adjustment expenses	7,254			2,576			10,486			6,258
Policy acquisition costs	1,515			2,638			6,034			6,798
Other operating expenses	14,553			11,999			46,270			35,293
Interest expense	70,943			76,095			223,688			213,478
Depreciation and amortization	2,103			2,456			6,640			7,173
Total expenses	96,368			95,764			293,118			269,000
(Income) loss of minority interest	1,590			(897		)	(554		)	(3,126		)
Income (loss) before income taxes	(1,599,709		)	25,851			(1,723,020		)	65,655
Provision for income tax expense (benefit)	(558,685		)	9,790			(600,077		)	23,405
Net income (loss)	$	(1,041,024	)	$	16,061		$	(1,122,943	)	$	42,250

Share and Per Share Data
Earnings (loss) per share
Basic	$	(29.42	)	$	0.70		$	(31.05	)	$	1.85
Diluted	$	(29.42	)	$	0.53		$	(31.05	)	$	1.40

Weighted average shares outstanding
Basic	35,390			23,028			36,165			22,897
Diluted	35,390			30,236			36,165			30,129

See notes to unaudited condensed consolidated financial statements.

ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (UNAUDITED)

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006

(Dollars in thousands, except for share amounts)

							Gross					Notes						Accumulated
	Preferred Stock			Common Stock			Paid in and					Receivable						Other			Retained			Total
					Par		Contributed		Treasury			from			Deferred			Comprehensive			Earnings			Stockholders’
	Shares	Amount		Shares	Value		Capital		Stock			Stockholders			Compensation			Income (Loss)			(Deficit)			Equity
BALANCE—January 1, 2006	2,786,857	$	226,460	6,442,950	$	644	$	125,184	$	(5,500	)	$	(1,355	)	$	(2,030	)	$	11,132		$	29,778		$	384,313
Comprehensive income:
Net income	—	—		—	—		—		—			—			—			—			42,250			42,250
Change in unrealized gain on investments, net of change in deferred income tax of $1,904	—	—		—	—		—		—			—			—			2,670			—			2,670
Change in derivative hedges, net of change in deferred income tax of $(15)	—	—		—	—		—		—			—			—			(27		)	—			(27		)
Foreign exchange unrealized loss																		(18		)				(18		)
Total comprehensive income	—	—		—	—		—		—			—			—			—			—			44,875
Vesting of Series B senior convertible preferred stock to CEO	—	—		—	—		—		—			—			870			—			—			870
Exercise of stock options by former executives	—	—		663,540	66		8,024		—			—			—			—			—			8,090
Common stock purchased from former executive	—	—		—	—		—		(6,588		)	—			—			—			—			(6,588		)
Stock based compensation-stock options	—	—		—	—		578		—			—			—			—			—			578
Issuance of note receivable from stockholder	—	—		—	—		—		—			(2,262		)	—			—			—			(2,262		)
Discharge of note receivable from stockholders	—	—		—	—		—		—			496			—			—			—			496
Senior convertible preferred stock dividend	25	1,957		—	—		—		—			—			—			—			(1,957		)	—
BALANCE—September 30, 2006	2,786,882	$	228,417	7,106,490	$	710	$	133,786	$	(12,088	)	$	(3,121	)	$	(1,160	)	$	13,757		$	70,071		$	430,372

BALANCE—January 1, 2007	—	$	—	37,375,123	$	3,737	$	438,935	$	(12,088	)	$	(3,121	)	$	(870	)	$	(3,308	)	$	86,529		$	509,814
Effect of adoption of FIN 48	—	—		—	—		—		—			—			—			—			(1,500		)	(1,500		)
Comprehensive loss:
Net loss	—	—		—	—		—		—			—			—			—			(1,122,943		)	(1,122,943		)
Change in unrealized loss on investments, net of change in deferred income tax of $(135,070)	—	—		—	—		—		—			—			—			(250,844		)	—			(250,844		)
Change in derivative hedges, net of change in deferred income tax of $(3,907)	—	—		—	—		—		—			—			—			(7,256		)	—			(7,256		)
Foreign exchange unrealized gain	—	—		—	—		—		—			—			—			192			—			192
Total comprehensive loss	—	—		—	—		—		—			—			—			—			—			(1,380,851		)
Vesting of CEO restricted common stock	—	—		—	—		—		—			—			870			—			—			870
Stock repurchases	—	—		—	—		—		(14,996		)	—			—			—			—			(14,996		)
Offering costs	—	—		—	—		63		—			—			—			—			—			63
Stock based compensation—restricted stock	—	—		—	—		734		—			—			—			—			—			734
Stock based compensation—stock options	—	—		—	—		1,845		—			—			—			—			—			1,845
Exercise of common stock options	—	—		69,750	7		722		—			—			—			—			—			729
BALANCE—September 30, 2007	—	$	—	37,444,873	$	3,744	$	442,299	$	(27,084	)	$	(3,121	)	$	—		$	(261,216	)	$	(1,037,914	)	$	(883,292	)

See notes to unaudited condensed consolidated financial statements.

ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006

(Dollars in thousands)

	2007			2006
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)	$	(1,122,943	)	$	42,250
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization	6,640			7,173
Accrual of discount and amortization of premium on investment—net	504			(171		)
Income of minority interest	554			3,126
Net realized gain on sale of CDO equity investment	(39,577		)	—
Net realized losses on fixed-maturity securities-available-for-sale	124,062			3,857
Net realized and unrealized losses on fixed-maturity securities- trading	9,301			118
Net realized loss on other invested assets	550			—
Net realized and unrealized gains on derivative instruments	(2,939		)	(6,894		)
Net realized and unrealized (gains) losses on net insured credit swap revenue	1,738,453			(4,167		)
Net realized and unrealized (gains) losses on other net credit swap revenue	(15,536		)	149
Net foreign exchange loss	152			—
Share based compensation expense	2,579			578
Discharge of note receivable from shareholders	—			496
Deferred compensation	870			870
Securities purchased under agreements to resell -net	9,248			(32,066		)
Purchases of fixed-maturity securities-trading	(227,186		)	(82,792		)
Proceeds from sales of fixed-maturity securities- trading	245,460			(145,118		)
Proceeds from maturities of fixed-maturity securities- trading	89,285			—
Securities sold under agreements to repurchase - net	(128,103		)	235,679

Changes in assets and liabilities:
Income taxes payable	3,024			82
Deferred income tax expense	(631,361		)	3,219
Prepaid reinsurance premiums	64			249
Derivative liabilities	14,631			(2,871		)
Accrued expenses and other liabilities	(5,532		)	(6,785		)
Deferred policy acquisition costs	(2,029		)	(420		)
Unearned premium reserve	7,305			3,511
Loss and loss adjustment expenses	765			5,072
Interest payable	(4,560		)	1,583
Interest receivable	1,315			(4,373		)
Other	(12,585		)	(1,193		)
Net cash provided by operating activities	62,411			21,162

CASH FLOWS FROM INVESTING ACTIVITIES:
Net release (deposit) of restricted cash	15,573			(7,334		)
Purchases of fixed maturity securities available for sale	(694,504		)	(786,738		)
Redemption of guaranteed investment contract	119,340			—
Proceeds from sales of fixed maturity securities available for sale	86,109			89,843
Proceeds from maturities of fixed maturity securities available for sale	730,888			827,751
Deconsolidation of CDOs, net of equity sale proceeds	(34,336		)	—
Net purchase of property and equipment	(4,360		)	(298		)
Net cash provided by investing activities	218,710			123,224

CASH FLOWS FROM FINANCING ACTIVITIES:
Paydown of commercial paper—net	(2,520		)	5,228
Paydown on long-term debt	(364,062		)	(107,014		)
Purchase of treasury stock	(14,996		)	(760		)
Proceeds from issuance of equity in Credit Fund	3,000			8,600
Proceeds from exercise of stock options	729			—
Offering costs	63			—
Net cash used in financing activities	(377,786		)	(93,946		)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS	(96,665		)	50,440

CASH AND CASH EQUIVALENTS—beginning of period	379,905			174,420
CASH AND CASH EQUIVALENTS—end of period	$	283,240		$	224,860

SUPPLEMENTAL CASH FLOW DISCLOSURES:
Federal and local income taxes paid	$	28,601		$	20,236
Interest paid	$	222,375		$	211,894

SUPPLEMENTAL DISCLOSURES OF NON-CASH OPERATING ACTIVITIES:
Impact on assets and liabilities due to CDO deconsolidation
Cash and cash equivalents	$	(34,336	)	$	—
Interest receivable	$	(4,102	)	$	—
Derivative assets	$	(792	)	$	—
Deferred debt issuance costs	$	(11,905	)	$	—
Receivable for securities sold	$	(72	)	$	—
Other assets	$	431		$	—
Derivative liabilities	$	16,320		$	—
Interest payable	$	5,756		$	—

SUPPLEMENTAL DISCLOSURES OF NON-CASH INVESTING ACTIVITIES:
Impact on assets and liabilities due to CDO deconsolidation
Fixed maturity securities available for sale	$	(1,021,435	)	$	—

SUPPLEMENTAL DISCLOSURES OF NON-CASH FINANCING ACTIVITIES:
Common stock acquired in exchange for note receivable	$	—		$	2,262
Impact on assets and liabilities due to CDO deconsolidation
Long-term debt	$	1,089,712		$	—

See notes to unaudited condensed consolidated financial statements.

ACA CAPITAL HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2007

1. BUSINESS, ORGANIZATION AND OPERATIONS

ACA Capital Holdings, Inc. (“ACA” or the “Company”), is a Delaware domiciled holding company that provides financial guaranty insurance products to participants in the global credit derivatives markets, structured finance capital markets and public finance capital markets, as well as asset management services. The Company’s principal activities include financial guaranty insurance of public finance obligations, structured credit risk assumption through insured credit derivatives and collateralized debt obligation asset management. ACA conducts its business through three principal wholly-owned indirect subsidiaries. Its financial guaranty insurance business is conducted through ACA Financial Guaranty Corporation (“ACA Financial Guaranty”), a Maryland domiciled insurance company. ACA Financial Guaranty is licensed to conduct financial guaranty insurance business, which provides credit enhancement on public finance and other debt obligations, in all 50 states, the District of Columbia, Guam, the U.S. Virgin Islands and Puerto Rico. ACA Financial Guaranty also provides the credit support for the Company’s Structured Credit business activities. The Company conducts its U.S.-based CDO Asset Management business primarily through ACA Service L.L.C. and ACA Management, L.L.C. This business encompasses the origination (in collaboration with investment banks), structuring and management of collateralized debt obligations (including collateralized loan obligations and other similarly securitized asset classes, collectively “CDOs”). In January 2007, the Company’s wholly-owned indirect subsidiary, ACA Capital Management (U.K.) Pte. Limited, became authorized and regulated by the Financial Services Authority as an investment manager to manage CDOs in the United Kingdom and most of Europe.

The Company’s business is composed of three distinct continuing lines of business or segments. They are Public Finance, Structured Credit and CDO Asset Management. A fourth line of business, Other, includes business in areas and markets in which the Company is no longer active. Although the Public Finance and Structured Credit businesses are reported in separate segments, together they form the Company’s financial guaranty insurance business. Public Finance primarily provides financial guaranty insurance policies guaranteeing the timely payment of scheduled principal and interest on public finance and other debt obligations. Structured Credit structures and sells credit protection, principally in the form of insured credit default swaps (“CDS” or “credit swaps”), against a variety of asset classes in the institutional fixed income markets. CDO Asset Management focuses on CDO origination, structuring and management. The Company will at times assume risk in the CDOs it manages through investment in some portion of the capital structure.

ACA was originally incorporated in Delaware on January 3, 1997. On November 22, 2002, ACA changed its jurisdiction of incorporation from Delaware to Bermuda. During 2004, the Board of Directors determined that re-domesticating to Delaware would eliminate certain adverse consequences of remaining in Bermuda, facilitate ACA’s access to U.S. capital markets, simplify its tax filings, accounting and operations, and reduce the costs of compliance with two sets of filing obligations and laws (as ACA stockholders are U.S. entities and individuals). On September 15, 2004, therefore, ACA re-domesticated from Bermuda to Delaware through a process called a “discontinuation” under Bermuda law and “domestication” under Delaware law. As a result, it became a Delaware domiciled holding company and changed its name from American Capital Access Holdings, Ltd. to its current name.

On November 9, 2006, the Company priced its initial public offering of 6,875,000 shares of newly issued common stock and 23,541 shares of existing common stock. The Company realized gross proceeds of $13 per share on the newly issued common stock, or $89.4 million. Net proceeds to the Company were $79.2 million, after issuance costs. On November 10, 2006, the Company’s common stock commenced trading on the New York Stock Exchange under the symbol “ACA”. In conjunction with the initial public offering, the Company’s senior convertible preferred stock, convertible preferred stock and series B senior convertible preferred stock all converted to common stock concurrently with the closing of our offering on November 15, 2006 at their conversion ratios of 6,000:1 shares, 6,000:1 shares and 6:1 shares, respectively.

Standard & Poor’s Rating Services (“S&P”) has assigned a financial strength rating of “A” to ACA Financial Guaranty. On November 9, 2007, S&P placed its “A” rating of ACA Financial Guaranty on CreditWatch with negative implications (see Note 16).

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

These unaudited condensed consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements and should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 (“Form 10-K”), filed with the SEC on April 2, 2007. These unaudited condensed consolidated financial statements include all adjustments, consisting only of normal recurring adjustments, that we consider necessary for the fair presentation of our financial position and results of operations for these periods. The preparation of financial statements in conformity

with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Operating results for the three and nine months ended September 30, 2007 are not necessarily indicative of the results that may be expected for the year ended December 31, 2007.

In August 2006, the Company’s Board of Directors authorized a dividend of stock in order to effect a six-for-one stock split. All prior share and per share amounts have been restated to reflect the stock split.

Valuation of Insured Credit Swap Transactions — The Company values its insured credit swap transactions either by obtaining market quotes from dealers or through the application of the Company’s valuation model. During the quarter ended June 30, 2007, the Company refined its valuation model to estimate fair value of its insured credit swap transactions. The change was implemented to be more consistent with models that the Company understands other market participants utilize, including many of ACA’s insured credit swap counterparties. The relatively young market for credit swaps has continued to evolve over time and, while there is still substantial variance in valuation models among market participants, the trend is toward increasing convergence in this area. Under its refined model, the Company fully uses market spread data as a proxy for default probabilities in the determination of fair value. For transactions in which the underlying exposure is to corporate credits, the Company uses individual market spreads as proxies for defaults as they are readily available. Historically, for synthetic asset-backed transactions individual spread data has not been as readily available and the Company used current weighted average portfolio spreads as a proxy for individual spreads where necessary. However, in the third quarter of 2007, individual spreads were obtained for all transactions, including synthetic asset-backed transactions. The Company will continue to use individual market spread data when available. The Company believes that its refined model will inherently increase the volatility of these valuations, but provide a better estimate of the cost or benefit of unwinding the related transaction.

3. RELEVANT RECENT ACCOUNTING PRONOUNCEMENTS

On April 18, 2007, the Financial Accounting Standards Board (“FASB”) released an exposure draft entitled “Accounting for Financial Guarantee Insurance Contracts—An Interpretation of FASB Statement No. 60” (the “Proposed Statement”). While FASB Statement No. 60, “Accounting and Reporting by Insurance Enterprises”, sets out accounting standards for property and casualty and life insurance enterprises, it has historically not specifically considered financial guaranty insurance. This new interpretation is intended to address the specific attributes of this type of insurance. The principal items addressed in the exposure draft relate to revenue recognition, the establishment of claim reserves and disclosures around such reserves. In response to exposure draft comments the FASB received from financial guaranty insurance financial statement preparers, reviewers and users, the FASB is expected to issue a revised exposure draft in the first quarter of 2008. The proposed scope and effective date of this revised exposure draft are not known at this time. While certain provisions of the Proposed Statement are still being analyzed, management believes that the cumulative effect of initially applying the Proposed Statement or potential revisions could be material to the Company’s financial statements. Until the final interpretation is issued by the FASB, the Company continues to apply the accounting policies as disclosed in its Form 10-K.

In February 2007, the FASB issued Financial Accounting Standard (“FAS”) 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“FAS 159”). FAS 159 permits reporting entities to choose to remeasure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The fair value option may be applied instrument by instrument, is irrevocable and is applied only to entire instruments and not to portions of instruments. FAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. FAS 159 is effective for fiscal years that begin after November 15, 2007. The Company did not elect to early adopt FAS 159. Management is currently evaluating the potential impact, if any, which the adoption of FAS 159 will have on the Company’s financial statements.

On January 1, 2007, the Company adopted FAS 155, “Accounting for Certain Hybrid Financial Instruments” (“FAS 155”), an amendment of FAS 133, “Accounting for Derivative Instruments and Certain Hedging Activities” (“FAS 133”) and FAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“FAS 140”). The implementation of this statement did not have a material impact on the Company’s financial statements.

On January 1, 2007, the Company adopted FASB Interpretation No. (“FIN”) 48, “Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement No. 109” (“FIN 48”). The adoption of FIN 48 resulted in a decrease to stockholders’ equity as of January 1, 2007 of $1.5 million (see Note 6).

In September 2006, the FASB issued FAS 157, “Fair Value Measurements” (“FAS 157”). FAS 157 enhances existing guidance for measuring assets and liabilities using fair value, such as emphasizing that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in active markets. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Management does not expect the adoption of FAS 157 to have a material impact on the Company’s financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB 108”), “Considering the Effects of Prior Year

Misstatements when Quantifying Misstatements in Current Year Financial Statements”, which provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The provisions of SAB 108 were put in effect at December 31, 2006. The adoption of this statement did not have a material impact on the Company’s financial statements.

In April 2006, the FASB issued Staff Position (“FSP”) FIN 46(R)-6, “Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)” (“FSP FIN 46(R)-6”). FSP FIN 46(R)-6 addresses whether certain arrangements associated with variable interest entities (VIEs) should be treated as variable interests or considered as creators of variability, and indicates that the variability to be considered shall be on based on an analysis of the design of the entity. FSP FIN 46(R)-6 was adopted on June 15, 2006. The adoption of this statement did not have a material impact on the Company’s financial statements.

In March 2006, the FASB issued FAS 156, “Accounting for Servicing of Financial Assets” (“FAS 156”), an amendment of FAS 140. FAS 156 requires that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable, and permits for subsequent measurement using either fair value measurement with changes in fair value reflected in earnings or the amortization and impairment requirements of FAS 140. The subsequent measurement of separately recognized servicing assets and servicing liabilities at fair value eliminates the necessity for entities that manage the risks inherent in servicing assets and servicing liabilities with derivatives to qualify for hedge accounting treatment and eliminates the characterization of declines in fair value as impairments or direct write-downs. FAS 156 is effective for an entity’s first fiscal year beginning after September 15, 2006. The implementation of this statement did not have a material impact on the Company’s financial statements.

In September 2005, Statement of Position (“SOP”) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts”, (“SOP 05-1”), was issued. This SOP provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacement of insurance and investment contracts other than those specifically described in FAS No. 97, “ Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments “. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The adoption of this SOP did not have a material impact on the Company’s financial statements.

4. CDO ASSET MANAGEMENT BUSINESS

One of the ways the Company participates in the structured finance market is through structuring and managing CDOs originated in collaboration with investment banks. CDOs can be issued in funded, unfunded or partially funded form. Funded CDOs issue debt instruments and purchase investment assets, while unfunded CDOs synthetically acquire assets and issue liabilities (i.e., assets and liabilities are in derivative form). Partially funded CDOs are a combination of these two forms. From an accounting perspective, funded and partially funded CDOs are determined to be VIEs. Each time such CDOs are formed, the Company performs an analysis to determine whether it is the primary beneficiary and thus required to consolidate the CDO under the provisions of FSP FIN 46(R)-6. Upon the occurrence of a reconsideration event in accordance with FIN 46(R)-6, such as the sale or disposal of all or part of the Company’s equity investment, the Company re-performs its analysis to determine whether it is still the primary beneficiary.

The following table lists each of the Company’s CDOs outstanding as of September 30, 2007 (dollars in millions):

Year

Original

First

Deal

Transaction

Notional

Investment in

Retained

Optional

Maturity

CDO name

Closed

Type

Collateral Type (1)

Deal Size (3)

Consolidated

Retained Equity

Equity %

Call Date(4)

Date

Asset-Backed CDOs:

ACA ABS 2002-1

2002

Funded

Investment Grade

404

18.0

100

8/2005

8/2037

ACA ABS 2003-1

2003

Funded

Investment Grade

400

18.0

100

6/2007

6/2038

Grenadier Funding

2003

Funded

High-Grade

1,500

Yes

22.5

100

8/2008

8/2038

ACA ABS 2003-2

2003

Funded

Investment Grade

725

33.5

100

12/2007

12/2038

ACA ABS 2004-1

2004

Funded

Investment Grade

450

Yes

10.0

7/2007

7/2039

Zenith Funding

2004

Funded

High-Grade

1,511

Yes

13.0

12/2009

12/2039

ACA ABS 2005-1

2005

Funded

Investment Grade

452

4.4

4/2008

4/2040

ACA ABS 2005-2

2005

Funded

Investment Grade

450

2.1

9/2009

12/2044

Khaleej II

2005

Partially funded

Investment Grade

750

4.5

9/2009

9/2040

Lancer Funding

2006

Funded

High-Grade

1,500

1.5

7/2010

4/2046

ACA Aquarius 2006-1

2006

Partially funded

Investment Grade

2,000

—

9/2010

9/2046

ACA ABS 2006-1

2006

Funded

Investment Grade

750

1.4

12/2009

6/2041

ACA ABS 2006-2

2006

Funded

Investment Grade

750

3.5

1/2011

1/2047

ACA ABS 2007-1

2007

Partially funded

Investment Grade

1,500

1.4

3/2010

5/2047

Millbrook

2007

Unfunded

Investment Grade

—

3/2010

10/2052

Abacus 2007-AC1

2007

Unfunded

Investment Grade

192

—

6/2010

3/2038

ACA ABS 2007-2

2007

Partially funded

Investment Grade

750

—

7/2011

7/2045

Lancer II

2007

Partially funded

High-Grade

1,000

—

7/2011

7/2047

ACA ABS 2007-3

2007

Partially funded

Investment Grade

350

—

8/2013

5/2047

Total Asset-Backed CDOs

15,496

133.8

Corporate Credit CDOs:

ACA CDS 2002-2

2003

Unfunded

Investment Grade

1,000

25.0

100

N/A

3/2008

Argon 49

2005

Funded

Investment Grade

(2)

—

N/A

6/2015

Argon 57

2006

Funded

Investment Grade

(2)

—

N/A

6/2013

Tribune

2006

Unfunded

Investment Grade

217

(5)

—

N/A

9/2016

Dolomite

2007

Unfunded

Investment Grade

(2)

—

N/A

7/2014

Total Corporate Credit CDOs

1,430

25.0

Leveraged Loan CDOs:

ACA CLO 2005-1

2005

Funded

Non-Investment Grade

300

5.0

10/2009

10/2017

ACA CLO 2006-1

2006

Funded

Non-Investment Grade

350

—

7/2009

7/2018

ACA CLO 2006-2

2006

Funded

Non-Investment Grade

300

2.2

1/2011

1/2021

ACA CLO Euro 2007-1

2007

Funded

Non-Investment Grade

571

(2)

5.5

6/2010

6/2024

ACA CLO 2007-1

2007

Funded

Non-Investment Grade

350

2.7

6/2011

6/2022

Total Leveraged Loan CDOs

1,871

15.4

Total

18,797

174.2

(1) Based on original rating, investment grade collateral is rated “BBB-” or better; however certain of our investment grade CDOs include the ability to invest a minority portion (20% or less) in non-investment grade assets. High-grade is “A-” or better.

(2) The original notional deal sizes for Argon 49 and Argon 57 were €50 million each, and that for Dolomite was €49 million and $1 million. The original deal size for ACA CLO Euro 2007-1 was €400 million. For purposes of this chart, we have converted the amounts to U.S. dollars at the prevailing currency exchange rate on September 30, 2007.

(3) Notional deal size is defined as total liabilities at the deal’s inception.

(4) Cash flow CDOs are generally callable once per quarter by a majority or greater vote of the equity holders on a specific date as negotiated, which is referred to as the First Optional Call Date.

(5) Tribune is comprised of 11 distinct trades some of which are denominated in Euros or Yen. For purposes of this chart, we have converted the respective amounts to U.S. dollars at the prevailing currency exchange rates on September 30, 2007.

As of September 30, 2007 and December 31, 2006, consolidated liabilities include non-recourse debt from consolidated CDOs of $3,258.0 million and $4,711.8 million, respectively. Also, as of September 30, 2007 and December 31, 2006, consolidated assets include investments in CDO related fixed maturity securities and guaranteed investment contracts of $2,772.6 million and $4,656.0 million, respectively, and cash of $225.0 million and $265.0 million, respectively.

During the third quarter of 2007, the Company sold a portion of its equity investment in three CDO deals, ACA ABS 2002-1, ACA ABS 2003-1 and ACA ABS 2003-2, each for fair market value to an independent third party. In conjunction with the equity sale, the Company determined that it was no longer the primary beneficiary of these deals under FIN 46(R), “Consolidation of Variable Interest Entities — an interpretation of ARB No. 51” (“FIN 46(R)”) and, therefore, de-consolidated these deals in its financial statements, realizing a net gain of $39.6 million. The gain was primarily related to the reversal of previously realized losses in excess of the Company’s original equity investment. The de-consolidation also resulted in a decrease in both assets, primarily fixed-maturity securities available for sale, and liabilities, primarily long-term debt, of approximately $1.0 billion, as well as an increase to accumulated other comprehensive income of $66.4 million. The decreases in fixed-maturity securities available for sale and long-term debt will result in a reduction of related investment income and interest expense in the Company’s statement of operations in future periods.

Beginning in 2005, the Company has retained a lesser share of the equity position of newly issued CDOs. Based on analyses under FIN 46(R), the Company is not deemed to be the primary beneficiary of these VIEs. As a result, these CDOs are not consolidated in the financial statements. Rather, the non-majority investment is recorded as an investment in a single fixed maturity security under the provisions of FAS 115 and Emerging Issues Task Force (“EITF”) Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“EITF 99-20”). The deconsolidated CDOs described in the paragraph above are also accounted for under this principle. During the first nine months of 2007, the Company closed nine CDOs and purchased an equity interest in three. During 2006, the Company closed eight CDOs and purchased an equity interest in four. During 2005, the Company closed five CDOs and purchased an equity interest in four. The Company was not determined to be the primary beneficiary in any of these CDOs and therefore did not consolidate them.

5. NET INSURED CREDIT SWAP REVENUE AND OTHER NET CREDIT SWAP REVENUE

Net insured credit swap revenue includes insured credit swap premiums received for credit protection the Company has sold under its insured credit swaps as well as realized and unrealized gains and losses related to those transactions. Realized losses arise upon the occurrence of credit events requiring payment by the Company under the related credit swap and, additionally, realized gains or losses could occur if a transaction is terminated in advance of its scheduled termination date. Unrealized gains and losses represent the adjustments for changes in fair value that are recorded in each reporting period, under FAS 133. The fair value of the Company’s insured credit swaps are recorded as either a derivative liability or derivative asset in the consolidated balance sheets.

The following table disaggregates net insured credit swap revenue into its component parts for the three months and nine months ended September 30, 2007 and 2006:

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2007			2006		2007			2006
	(in thousands)
Net insured credit swap revenue
Insured credit swap premiums earned	$	28,147		$	13,742	$	70,509		$	35,023
Unrealized gains (losses) on insured credit swaps	(1,655,607		)	3,337		(1,738,453		)	2,158
Realized gains on insured credit swaps	—			—		—			2,009
Total net insured credit swap revenue	$	(1,627,460	)	$	17,079	$	(1,667,944	)	$	39,190

Of the $(1,655.6) million unrealized loss recorded in the three months ended September 30, 2007, $(1,652.1) million was related to valuation changes in the Company’s Structured Credit line of business transactions. The residential mortgage-backed securities (“RMBS”) portion of the Structured Credit portfolio incurred valuation losses of $(1,493.8) million for the three months ended September 30, 2007. However, no realized or actual losses were incurred on this portfolio based on its very high credit quality, with over 99% of the portfolio constructed of exposures attaching above the “AAA” rated level of subordination. These valuation losses were precipitated by the severe level of delinquencies and defaults that have occurred in the residential mortgage market, particularly in the sub-prime and second lien segments, which constitute a significant portion of the assets underlying the RMBS included in the pools of assets referenced by certain of our Structured Credit transactions. Additionally, the Company recorded unrealized losses of $(158.3) million on its Structured Credit’s corporate credit portfolio for the three months ended September 30, 2007. The valuation losses on the corporate portfolio resulted from wider spreads at September 30, 2007, than at June 30, 2007. It is the Company’s intention to generally hold its insured credit swaps to term, absent credit losses, these unrealized amounts will revert to $0 at contract expiration, if the Company so held the position.

Other net credit swap revenue includes revenues received from a partially funded CDS CDO, which sells credit protection under credit swaps for which it receives fixed quarterly fees, the residual returns on two synthetic equity participations and the cost of credit protection purchased in the form of a credit default swap. This credit protection was purchased to hedge against our exposure to RMBS in our CDO Asset Management line of business. It also includes trading activity in credit default swaps by the Credit Fund. Other net credit swap revenue also includes net realized and unrealized gains and losses associated with these transactions, if any. As of June 30, 2007, the Company’s risk to the partially funded CDS CDO and one of the synthetic equity participations had expired. These revenues were included in the Company’s consolidated statement of operations for periods prior to that date. The following table disaggregates other net credit swap revenue into its component parts for the three months and nine months ended September 30, 2007 and 2006:

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2007			2006			2007			2006
	(in thousands)
Other net credit swap revenue
Credit swap fees earned	$	(2,395	)	$	2,530		$	3,415		$	7,783
Unrealized gain on credit protection purchased	3,242			—			14,816			—
Unrealized gains on credit swaps - credit fund	1,947			—			1,667			—
Unrealized losses on credit swaps - CDOs	—			(440		)	(947		)	(149		)
Total other net credit swap revenue	$	2,794		$	2,090		$	18,951		$	7,634

6. INCOME TAXES

Effective January 1, 2007, the Company adopted the provisions of FIN 48. As a result, the Company recorded a $1.5 million reserve for uncertain tax positions and a corresponding decrease to the 2007 opening retained earnings. The Company’s effective tax rate would have increased if this amount was recognized as a tax expense. It is unlikely that the unrecognized tax expense will significantly change in the next 12 months.

The Company files income tax returns in the U.S, federal jurisdiction, and various states and foreign jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2003.

The Company records interest and penalties related to unrecognized tax benefits in income taxes, $0.5 million in accrued interest and penalties is included in the $1.5 million reserve for uncertain tax positions related to our adoption of FIN 48. Additional accrued interest and penalties of $0.4 million were recognized during the first nine months of 2007 increasing the reserve for uncertain tax positions to $1.9 million.

Our tax provision for interim periods is determined using an estimate of our annual effective tax rate. The 2007 effective tax rate is estimated to be equal to the 35% statutory rate.

The Company, as a financial guaranty insurance writer, is eligible for a tax deduction, subject to certain limitations, under Section 832(e) of the Internal Revenue Code for amounts required by state law or regulation to be set-aside in statutory contingency reserves. The deduction is allowed only to the extent that the Company purchases non-interest-bearing U. S. Mortgage Guaranty Tax and Loss Bonds (“T&L bonds”) issued by the Treasury Department in an amount equal to the tax benefit derived from deducting any portion of the Company’s statutory contingency reserves. We record these bonds on our balance sheet in current federal income taxes. Purchases of T&L bonds are a prepayment of federal income taxes that becomes due in ten years, when the contingency reserve is released and the T&L bonds mature. The proceeds from the maturity from the T&L bonds are used to fund the income tax

payments. The total T&L bonds recorded in current federal income tax payable as of September 30, 2007 is $18.3 million.

At September 30, 2007, the Company had federal capital loss carryforwards of approximately $30.4 million that begin to expire in 2010 and are fully expired by 2012. Based on available evidence, it is more likely than not that the deferred tax assets relating to the capital loss will not be fully realized. Accordingly, a valuation allowance was established in September 30, 2007 in the amount of $4.0 million relating to the portion of the tax benefits attributable to certain capital losses.

7. LITIGATION

In May 2006, the Company paid a judgment in the amount of $3.7 million in satisfaction of a damages award in connection with an employment contract dispute with a former executive of the Company plus accrued interest through the date of payment. Also in May 2006, the Company settled the former executive’s attorney’s fees at an additional amount of $0.6 million. The Company had recorded a reserve of $4.2 million to cover these costs in December 2005. A judicial satisfaction of the judgment has been filed and the Company has no additional liability with respect to this matter.

The Company is not aware of any pending or threatened litigation that it believes could reasonably be likely to result in a material adverse effect on the Company’s financial position, results of operations or cash flows.

8. SEGMENT INFORMATION

The Company’s reportable segments are as follows:

(1) Structured Credit, which structures and sells credit protection, principally in the form of insured credit swaps, against a variety of asset classes in the institutional fixed income markets;

(2) Public Finance, which provides insurance guaranteeing the timely payment of principal and interest on public finance and other debt obligations;

(3) CDO Asset Management, which originates, structures and manages assets, primarily corporate obligations or asset-backed securities, in funded, partially funded or synthetic CDOs; and

(4) Other, which primarily includes trade credit insurance business and financial guaranty insurance on certain other sectors, each of which the Company is no longer engaged in.

The Company’s first three reportable segments are strategic business units that offer different products and services. They are managed separately since each business requires different marketing strategies, personnel skill sets and technology.

Where determinable, the Company specifically assigns assets to each segment, otherwise, the Company allocates assets based on estimates. In general, allocation percentages for assets are determined based on each line’s estimated capital utilization from a rating agency perspective.

The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company evaluates segment performance based on its income (loss) before income taxes. Reportable segment results are presented net of material inter-segment transactions. The following tables summarize the Company’s operations and allocation of assets as of and for the three months and nine months ended September 30, 2007 and 2006 (dollars in thousands):

	Three Months Ended September 30, 2007
	Structured			Public			CDO Asset						Consolidated
	Credit			Finance			Management			Other			Totals
REVENUES:
Gross premiums written	$	36		$	6,997		$	—		$	80		$	7,113

Premiums earned	$	36		$	5,302		$	—		$	190		$	5,528
Net insured credit swap revenue	(1,624,766		)	(520		)	(2,174		)	—			(1,627,460		)
Net investment income	4,722			4,576			74,964			3,209			87,471
Net realized and unrealized gains (losses) on investments	(7,142		)	(209		)	26,916			(51		)	19,514
Net realized and unrealized losses on derivative instruments	(33		)	—			(2,364		)	—			(2,397		)
Other net credit swap revenue	(496		)	—			3,290			—			2,794
Fee and other income	180			58			9,381			—			9,619
Total revenues	(1,627,499		)